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Understanding the Financial Process of “Hedging”

Hedging is a very important financial concept and process. Basically, it is a process by which you reduce risk and exposure from a risk asset by purchasing some sort of protection against a price drop. Often, this hedging protection is gained by using a futures contract. Futures are contracts that allow you to buy assets in the future at a price you have already agreed upon right now. The contract gives you the option but not obligation to buy an asset, which means that you can exercise this option to buy or sell at a better price than prevailing market contracts.

In many ways, hedging is like buying insurance for your investments. In fact, one simple hedging definition is to call it “insurance on your investments”. You are creating protection for your portfolio should markets not act they way you predict. Risks are inherent in investing, but hedging can allow you to reduce them. Of course, in order to reduce risks, you’ll also have to reduce the potential reward.

Let’s say you buy stocks in Google, a very popular technology company. Assuming that stocks are currently selling for $800 dollars, and you believe their hot new augmented reality technology is going to generate a lot of publicity and send stocks soaring even higher. However, a lot of people have been hyping Google, and stock prices are near historical highs. This means that the risks of investing are also quite high. Let us assume that the announcement date for the AR technology is in 28 days. You’re holding onto $100,000,000 dollars worth of Google stock, which is a huge sum even for a big hedge fund.

Imagine you’re a hedge fund manager and you’re managing over a lot of people’s wealth. You don’t want to put that wealth at risk if you can avoid it, so you buy futures contracts to sell Google at $805 within 30 days for $15 dollars an option. Suddenly, the day before Google’s big unveiling of their augmented reality technology, the company cancels the event. Rumors are circulating that the AR tech is causing people to have seizures, and it looks like the technology is a flop.

Stock prices start collapsing. Investors everywhere are losing their shirt, thinking that they were investing in a safe technology that, in fact, turned out to be dud. However, you were smart and had hedged your bets beforehand. You lost money, both what you spent on the futures contraction, and also the slight difference between the future and the stock ($805 vs. $807), but unlike everyone else, your losses are actually quite muted. You were able to limit your losses because you hedged your bets.

So what is hedging? It’s a way to protect your investments. You made a prediction, Google’s AR tech was going to be world-changing. You were wrong. But you were also smart, and made sure to limit exposure. Kudos.

As a financial investor you’ve lost some money, but you’ve also proven your chops and savvy. You protected your clients while many others failed to do so. So while your investors might be upset that you made a bad bet, many will appreciate that you covered yourself by hedging with futures contracts.

So basically, the hedge definition can be thought of as lowering risks through the use of futures and other assets to guard against declining prices. We hope this answers the question “what is hedging”, but if you need more information there are plenty of other resources out there.

Now Let’s Define Hedge Fund

The hedging definition is quite a bit different from how one would define hedge fund. A hedge fund is sometimes confused with hedging, but actually the terms are quite a bit different. Hedge funds are eventually pools of money that are then managed by professional investors. Basically, a bunch of people will put their money into a hedgefund, and then a manager will invest it. Returns and profits are then shared among investors according to how much they put it.

Some hedge funds are actively managed. This means that the managing investors select stocks, and in exchange charge a fee. Other hedge funds are pegged to asset prices, such as the Dow Jones Industrial Average. Actively managed hedge funds almost always feature higher fees than passively managed ones. Keep that in mind if you’re selecting a hedge fund.